The formula compares the final value of investing domestically (Strategy A) vs. converting, investing abroad, and hedoning back via a Forward Contract (Strategy B). If the two differ, an arbitrage window is open.
Covered Interest Arbitrage (CIA) is a trading strategy that exploits temporary inefficiencies in the forex market. It happens when the interest rate differential between two countries is not exactly reflected in the forward exchange rate.
It is called Covered because the exchange rate risk is completely eliminated (hedged) using a Forward Contract. You are not betting on the currency going up or down; you are locking in a mathematical profit based on pricing errors.
The 4-Step Mechanism
To execute a CIA trade, you typically perform four simultaneous actions:
Borrow currency A (Domestic).
Convert currency A to currency B (Foreign) at the Spot Rate.
Invest currency B at the Foreign interest rate.
Sell the future proceeds of currency B forward (using a Forward Contract) to convert back to currency A at maturity.
If the profit from this loop is greater than interest you owe on the loan, you keep the difference. This is a pure arbitrage profit.
Step-by-Step Example
Let's say:
US Interest Rate: 2%
UK Interest Rate: 4%
Spot Rate: 1.50 USD/GBP
Forward Rate (1 yr): 1.48 USD/GBP
The Calculation:
1. Borrow $1,000,000 at 2%. In one year, you owe $1,020,000.
2. Convert $1,000,000 to GBP at 1.50. You get £666,666.
3. Invest £666,666 at 4%. In one year, you have £666,666 × 1.04 = £693,333.
4. Sell forward at 1.48. Convert £693,333 back to USD. £693,333 × 1.48 = $1,026,133.
The Result:
Proceeds: $1,026,133 Loan Repayment: $1,020,000 Net Profit: $6,133
You made $6,133 without using any of your own money and taking zero market risk.
Why Retail Traders Can't Do This
If it's so easy, why isn't everyone rich? Friction.
Bid-Ask Spreads: Banks charge a spread on Spot, Forward, and Rates. You buy at the high price and sell at the low price. This eats up small margins instantly.
Capital Access: You cannot borrow at the "Risk-Free Rate" (Libor/Sofr). You borrow at Retail rates (Prime + X), which destroys the math.
Size: Arbitrage usually requires millions of dollars to generate meaningful absolute profit.
Hidden Risks
Even for banks, CIA is not perfectly safe:
Counterparty Risk: The bank on the other side of your Forward contract could go bankrupt (Lehman Brothers scenario).
Operational Risk: If one leg of the trade fails or delays execution by seconds, the market moves and the profit vanishes.
Frequently Asked Questions
Expert answers on arbitrage trading
What is the difference between CIA and Carry Trade?
In CIA, you hedge your risk with a forward contract. In Carry Trade, you do NOT hedge; you hope the exchange rate stays stable. CIA is risk-free (theoretically), Carry Trade is high risk.
How fast do these opportunities disappear?
Milliseconds. High-Frequency Trading (HFT) algorithms constantly scan for these discrepancies and execute trades instantly, forcing the prices back into alignment.
Which way does the arbitrage force prices?
Capital flows into the undervalued asset. If the Forward is too high, everyone sells it. This selling pressure drives the Forward price down until Parity is restored.
Does this work with crypto?
Yes, this is very popular in crypto via "Cash and Carry." Buying Spot Bitcoin and selling Futures Bitcoin (when futures are at a premium) locks in the spread risk-free.
What is "Negative Basis"?
A situation where CIA dictates a profit, but banks cannot execute it due to balance sheet constraints (regulations). This leaves money on the table, creating a persistent anomaly.
Do I need a Forward Contract?
Yes. Without a Forward Contract, you are exposed to FX risk. If the currency crashes, you lose money. With the contract, your exchange rate in the future is guaranteed.
What happens if interest rates change?
If you have already locked in your trade, interest rate changes don't affect your profit (assuming fixed rate borrowing). The market spots/forwards will move for new entrants, but your contract is set.
Can I use Futures instead of Forwards?
Yes, Futures are exchange-traded versions of Forwards. They are standardized and liquid, making them easier for retail traders to access than OTC Forwards.
Why is "Domestic" usually USD?
It doesn't have to be. But the USD is the world reserve currency, so most textbooks and interbank quotes use USD as the reference point for calculations.
Is profit guaranteed?
Mathematically, yes. Practically, no. Execution slippage, wide spreads, and counterparty defaults are real risks that can turn a theoretical profit into a loss.
Summary
The Covered Interest Arbitrage Calculator identifies deviations from market efficiency.
It calculates the net profit of a fully hedged cross-currency investment strategy.
While theoretical opportunities are rare for individuals, this tool demonstrates the mechanics of global capital flows.
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Check deviations from interest rate parity and infer covered arbitrage direction.
How to use Covered Interest Arbitrage Calculator
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Frequently asked questions
How do I use the Covered Interest Arbitrage Calculator?
Simply enter your values in the input fields and the calculator will automatically compute the results. The Covered Interest Arbitrage Calculator is designed to be user-friendly and provide instant calculations.
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Are the results from Covered Interest Arbitrage Calculator accurate?
Yes, our calculators use standard formulas and are regularly tested for accuracy. However, results should be used for informational purposes and not as a substitute for professional advice.